Option Investor

Daily Newsletter, Wednesday, 01/11/2006

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Trader's Corner

Market Wrap

Storms Hit Again, Sweep Bears out to Sea

Katrina and Rita swirled to life again today. DuPont warned in part due to the effects of the two storms. Oil explorer giant BP alerted investors that the fourth-quarter's production had taken a greater hit than had the third, due to the storms' impact.

Those warnings were joined by one from Compuware Corp. (CPWR). Gusts buffeted the indices early in the day, but in the end, switched and blew the bears out to sea. Most sectors turned in positive performances. This occurred despite the lackluster advance/decline line performance, with the line's low level mimicking a low barometer reading of the type that signals that something ominous might be building far out at sea.

For now, only blue skies are visible. Over the last week, indices have climbed into one round-number resistance level after another, and today was the Wilshire 5000's turn.

Annotated Daily Chart of the Wilshire 5000:

The SPX also approached its own benchmark round-number level today, but couldn't quite press through that 1300 level. The futures contract did, however, near the close. The SPX's failure to push through 1300 might be offering another low barometer reading.

Despite those low barometer readings markets keep signaling in one form or another, this market remains one in which bulls have nothing more to do than to keep raising their stops. New entries sometimes prove more difficult to justify. New SPX bullish entries can be considered on tests of the 10-sma, but not if the SPX or other indices plunge. Any SPX plunge and close back below the 10-sma, especially if it should occur over the next couple of days, makes that breakout visible on the chart below look suspiciously like a trap for bulls.

Annotated Weekly Chart of the SPX:

If blue skies were the prediction today, it was Boeing (BA) that was winging through those blue skies. A top performer on the Dow, BA won a contract today from India for 68 planes. BA ended 2005 with a record number of sales, with some questioning when the manufacturer's sales might slow after such a record. Not yet, apparently.

Annotated Daily Chart of the Dow:

Some technical analysis techniques suggest next resistance on the Dow at 11,080-11,136, levels it's possible to reach over the next couple of days. This is based in part on the sometimes-seen tendency for consolidation to occur about halfway through a move and the FIB retracement levels projected from that consolidation. November and December's range-bound behavior could have been that type of consolidation. Longs should be raising stops, advice offered unnecessarily lately as the Dow climbs, but that doesn't mean that it's bad advice.

Bulls looking for new entries could watch for retests of and bounces from the 10-sma, although they should not consider an entry there if the Dow falls precipitously. A decline to 10,726-10,728 might be in store if a fall is precipitous. If entering long on a bounce from the 10-sma, guard profits carefully, as it will be the quality of the bounce that predicts whether the Dow will charge up toward a possible 11,300 Fib target. There are those low barometer readings to keep in mind.

Techs led the advance today, and Nasdaq bulls should follow that sound account-management advice, too, by continually cinching up stops.

Annotated Daily Chart of the Nasdaq:

The SOX certainly wasn't buffeted by those early ill winds from warning companies. Despite the presence of at least three gaps in the SOX's climb, typically a warning that the rally is exhausting itself, the SOX managed a more-than-two-point gap higher this morning, and it closed higher by 1.64 percent.

Annotated Daily Chart of the SOX:

Although of course not a component of the SOX, yesterday's report from Apple (AAPL) buoyed techs, and SOX component Broadcom (BRCM) received an upgrade, as did HPQ. Prudential upgraded HPQ to an overweight rating. Komag (KOMG), a manufacturer of thin-film disks, raised its outlook for revenue for the fourth quarter, and it leaped higher at the open, breaking above its August high. KOMG hasn't been hurt at all by a J.P. Morgan downgrade in December, climbing straight off the December low reached a few days later. Its climb is beginning to look a little overdone to the upside, however, and volume/price patterns today suggested that there could have been some selling into KOMG's rise, but there's not enough evidence to suggest a short play.

Although the SOX led indices higher today, other typical momentum plays didn't work as well if betting to the upside. Fast runners YHOO, GOOG and CME showed various possible signs of flagging strength: a gap lower, a doji, a failure to push above a recent high. If there's a storm somewhere out at sea, it may pass far away from shore, and these fast runners may run higher again, but their failure to participate as fully as some other stocks did prove intriguing.

The Russell 2000 also contributed to that low barometer reading that troubles some. Usually a leader, the RUT could not effectively build on this week's gains.

Annotated Weekly Chart of the Russell 2000:

The TRAN dropped today, with this typical market leader also offering its own version of a low barometer reading. After hitting its upside target, it's languished over the last couple of weeks. The drawback has not been deep enough to predict a plummet in this index or in others, but it should be watched.

Annotated Weekly Chart of the TRAN:

The day proved light on economic releases. The Mortgage Bankers Association released mortgage applications, showing those rising for the first time in five weeks. Countrywide Financial Corp. (CFC) announced that December mortgage funding rose 17 percent from the year-ago level, with the fourth quarter's loans up 40 percent from year-ago level. CFC and other major lenders headed higher.

Home Depot (HD), which had been sinking along with the DJUSHB, has been propelled higher this week by a positively viewed attempt to diversify its business away from the retail sector. Its addition to the Fresh Money Focus List and Bank of America's 30-Stock Model helped propel it further, and peer Lowe's (LOW) tagged along, too. Volume patterns on HD also suggest that there's some selling into the rally this week, but that overhead supply could be exhausted and HD could climb further, if so.

IIn other developments, Moody's downgraded Ford's credit ratings again, listing its outlook as "negative." The rating firm is said to be considering an upgrade of BBY's credit ratings. S&P revised its credit watch to GDT as "developing." While not good news, the news wasn't particularly surprising, and F gained 1.82 percent.


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With few economic releases, attention could focus on individual stock news and the crude inventories numbers. DuPont (DD) cited interruptions of production in Brazil, the Netherlands and the U.S. when it lowered its earnings estimate for the fourth quarter, specifically noting the impact of hurricanes Katrina and Rita. Some speculated that the fact that these were one-time events might limit the damage to DD. However, it closed lower by 3.31 percent. Sales of its crop protection chemical, performance coatings proved below expectations and its surfaces businesses did not perform as well as expected. The company trimmed its former $0.20-0.25 a share estimate to $0.10.

Compuware Corp. (CPWR) announced plans for major changes in the fourth quarter, after stating that third-quarter business did not meet expectations. Analysts had expected $0.11 a share for the third quarter, but CPWR now guides analysts to expect earnings of $0.09 a share. This software company said that demand had not been as strong as expected. CPWR dropped 13.06 percent. Interestingly, Mercury Interactive (MERQ), another software company, but this one based in Yehud, Israel, revised lower its estimate for revenue growth for the full year.

Genentech (DNA) met expectations on revenue and earnings, but Merrill Lynch downgraded the company based on lower-than-expected sales of Avastin. The company's stock dropped 4.41 percent.

Warning season has begun in Europe, too, with Europe's markets also reaching multi-year highs almost daily. This morning, PSA Peugeot Citroen offered its third warning since October, this time citing a greater-than-expected demand decline in Europe. German retailer Metro also warned, saying that 2005's earnings will be significantly below the year-ago level.

Crude inventories brought a stronger-than-anticipated drop in crude inventories, but stronger-than-expected builds in gasoline and distillate inventories. Analysts expected crude inventories to drop 555,000 barrels, but it instead dropped 2.9 million barrels according to the Department of Energy. Gasoline rose 4.52 million barrels, far more than the anticipated 1.73 million barrel climb, and distillates increased by 4.86 million barrels, also far more than its expected 2.13 million barrel increase. Despite the bigger-than-anticipated drop in crude inventories, those inventories remain above the upper end of the average range accumulated this time of year. The higher-than-expected builds in gasoline and distillates bring them into the upper end of the average range and the middle, respectively.

Crude prices had been dropping since Tuesday morning, dropping first to close a gap and then chopping sideways down most of Tuesday. The reaction to the crude inventories number dropped the CL contract through a rising trendline that had been building all of January, but then that contract bounced from the daily 10-sma. Currently, the contract for February delivery is up $0.15, to $64.09.

CNBC attributed the bounce to worries over the Iran situation. The OIX, Oil Index, and OSX, Oil Service Sector Index bounced at the inventories release. With big-caps such as BP, COP, and XOM comprising the OIX, a bounce in those sector indices served to help support the others.

BP bounced from a gap lower, however, with the company outlining further damage incurred as a result of the hurricanes that hit during the fourth quarter. The company's stock closed lower by 0.41 percent. The company now says it took a production hit of 160,000 barrels a day in the fourth quarter, a stronger hit than the 135,000-barrel-a-day hit taken in the third quarter, and its profit hit will be bigger, too. It's possible that the specter of lower production also put a floor under crude's decline.

JNJ dragged the healthcare sector lower after speculation that the company was attempting another counter-offer to BSX's bid for Guidant. Guidant's board supposedly met this afternoon to consider the two offers, but one source said that the company would not confirm the board meeting. JNJ closed lower by 0.95 percent.

Tomorrow's usual initial claims release might be crowded out of the limelight by November's trade balance, expected to narrow from the prior $68.9 billion deficit. Export and import prices will also be released. Natural gas inventories will be released at 10:30. At 2:00, December's treasury budget will be released. Earnings remain relatively light, but it might be warnings or raised guidance that could play a stronger part than the earnings.

Bulls should devote some time to planning profit-protection measures, and then to enjoying the offshore breezes, their plans safely made. A special warning should be devoted to the end-of-the week trading pattern, as several forces converge. Over the last year or so, the volatility that typically used to be seen on opex week now sometimes occurs the Thursday and Friday of the week before opex. That would be tomorrow and Friday. In addition, this precedes a three-day weekend, so there may be an even bigger push to adjust options positions, with a resultant move in the indices. It's possible that both bulls and bears could face some buffeting over the next few days. Such buffeting has been occurring in the Nikkei lately, with 200-300-point moves becoming more common, going either direction. Some charts compare the Nikkei with the SPX, and the correspondence has been remarkable, although there's not always a correspondence day to day. The Nikkei's action does, however, suggest that our markets might be due some similar buffeting.

Bears willing to stand on the beaches ahead of those hurricane winds have been swept out into the seas. If you're thinking bearish, you might consider waiting until there's a strong downdraft and then a choppy rise that fails.

New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
None None None

New Calls

None today.

New Puts

None today.

New Strangles

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Apollo Group - APOL - close: 62.13 change: -0.57 stop: 59.95

Uh-oh! Some bad news today in APOL has us reconsidering bullish positions. The company tried to put a positive spin on its appointment of a new president after its former president resigned. Wall Street tends to react negatively to unexpected management changes. More conservative traders may want to exit here. We're going to hold on to the play to see if APOL will bounce from its 10-dma near 61.40. We are not suggesting new positions. If APOL fails to push past the $63.50 level in the next several days we'll probably pull the plug early.

Picked on January 08 at $ 62.40
Change since picked: - 0.27
Earnings Date 03/16/06 (unconfirmed)
Average Daily Volume = 1.9 million


Biogen Idec - BIIB - close: 47.53 change: -0.43 stop: 44.45

Biotech stocks were mostly lower today. After six gains in a row for the BTK biotech index the BTK fell 0.6% sparked by selling in Genentech (DNA). DNA reported earnings last night that produced some sell the news movement today. BIIB is still consolidating under the $48.50 region and might dip to its 10-dma near 46.65. We are not suggesting new plays at this time. Our target for BIIB is the $49.85-50.00 range.

Picked on December 27 at $ 46.11
Change since picked: + 1.46
Earnings Date 02/15/06 (confirmed)
Average Daily Volume = 3.2 million


Caterpillar - CAT - close: 61.33 change: +0.03 stop: 56.95

Shares of CAT traded sideways on Wednesday. We see no change from our previous updates. Our target is the $64.75-65.00 range. We do not want to hold over the late January earnings report so we have just less than three weeks.

Picked on January 08 at $ 60.45
Change since picked: + 0.88
Earnings Date 01/26/06 (unconfirmed)
Average Daily Volume = 4.0 million


Gilead Sciences - GILD - close: 56.93 chg: -0.16 stop: 54.51

GILD spent most of the session trading sideways. Bulls should be okay as long as GILD remains above what should be support at the $56 level. Although it is arguable that the $55 level also offers some support. We are not suggesting new positions right here. We do not want to hold over GILD's mid January earnings report. Our target is the $59.00-60.00 range.

Picked on December 22 at $ 54.51
Change since picked: + 2.42
Earnings Date 01/17/06 (unconfirmed)
Average Daily Volume = 4.3 million


Goldman Sachs - GS - close: 131.97 chg: -0.06 stop: 127.45

The broker-dealer index continues to hit new highs. Yet shares of GS have seen their rally stall. We would expect GS to dip back to the $130 level. A bounce from $130 could be used as a new bullish entry point. Our target is the $134.80-135.00 range. More aggressive traders might want to aim higher.

Picked on January 09 at $130.05
Change since picked: + 1.92
Earnings Date 03/16/06 (unconfirmed)
Average Daily Volume = 3.6 million


Holly Corp. - HOC - close: 63.92 chg: -0.72 stop: 59.95

HOC is a new play from the Tuesday night newsletter. We do not see any change from our original play description. Our strategy involves a trigger to buy calls at $65.65, which would be a breakout to a new high and a new P&F buy signal (over $65.00). If triggered we'll target a quick rally into the $69.75-70.00 range before the company's early February earnings report. We do not want to hold over the earnings report.

Picked on January xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 02/06/06 (unconfirmed)
Average Daily Volume = 303 thousand


Lehman Brothers - LEH - close: 134.65 chg: +2.97 stop: 127.90*new*

LEH is leading the broker-dealer sector higher. The stock vaulted upward this morning and broke out to new all-time highs. Volume came in above average, which is bullish. We are raising our stop loss to $127.90. Our target is the $138.50-140.00 range over the next several weeks.

Picked on January 09 at $131.05
Change since picked: + 3.60
Earnings Date 03/14/06 (unconfirmed)
Average Daily Volume = 2.3 million


Ipsco Inc. - IPS - close: 83.72 change: -0.03 stop: 81.45

Bullish traders need to be very careful here. IPS may have only lost 3 cents today but the action looks pretty bearish. The stock rallied just high enough to fill the gap from Tuesday morning and then turn lower. It looks like shares of IPS are poised to turn even lower. Until the trend breaks we're going to keep the play alive. We are not suggesting new positions. More conservative traders may just want to exit early. We do not want to hold over the earnings report. Our target is the $89.00-90.00 range.

Picked on December 30 at $ 83.55
Change since picked: + 0.17
Earnings Date 01/24/06 (unconfirmed)
Average Daily Volume = 396 thousand


Lennar Corp. - LEN - close: 65.95 chg: +0.04 stop: 59.99

Shares of LEN consolidated sideways in a narrow range on Wednesday. We don't see any change from our previous updates. If there is any profit taking we'd watch for the $64.00-64.50 region to act as support. Our target now is the $69.50-70.00 range before February options expire.

Picked on January 09 at $ 64.01
Change since picked: + 1.94
Earnings Date 03/16/06 (unconfirmed)
Average Daily Volume = 2.6 million


Mohawk Ind. - MHK - close: 88.51 change: -1.29 stop: 86.90 *new*

MHK was weak today losing 1.4% on no news. This failed rally at the $90.00 level does not look like good news for the bulls. We are not suggesting new positions and more conservative traders may want to exit early right here. We are going to raise our stop to $86.90 in an effort to reduce our risk.

Picked on January 04 at $ 90.25
Change since picked: - 1.74
Earnings Date 02/02/06 (unconfirmed)
Average Daily Volume = 355 thousand


Petrochina Co - PTR - close: 89.05 change: +1.78 stop: 83.50

Double check those exit orders. PTR has almost reached our target in the $89.50-90.00 range. The stock added another 2% today on strong volume. More conservative traders may want to seriously consider just exiting right here for a gain.

Picked on January 03 at $ 83.50
Change since picked: + 5.55
Earnings Date 03/00/06 (unconfirmed)
Average Daily Volume = 488 thousand

Put Updates

Progressive Corp - PGR - cls: 118.06 chg: -0.50 stop: 119.15*new*

We still believe that bears are the ones at risk here. PGR has been trying to bounce for a week now and today's action produced another intraday rebound from its lows. More conservative traders may just want to bail out right now. We are choosing to keep the play open only because the major stock averages are short-term overbought and due for a decline. However, we will try and reduce our risk by lowering the stop loss to $119.15. We are not suggesting new positions.

Picked on December 30 at $117.45
Change since picked: + 0.61
Earnings Date 01/18/06 (confirmed)
Average Daily Volume = 836 thousand


Scotts Miracle grow - SMG - cls: 46.75 che: +0.00 stop: 47.05

SMG did not move much today and closed unchanged. We don't see any change from our previous update. More conservative traders may want to exit early to avoid further losses.

Picked on January 01 at $ 45.24
Change since picked: + 1.51
Earnings Date 01/26/06 (unconfirmed)
Average Daily Volume = 354 thousand

Strangle Updates

(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)


Amer. Eagle Out. - AEOS - cls: 25.55 chg: +0.94 stop: n/a

AEOS produced a very strong rally today adding 3.8% and breaking out over its exponential 200-dma. This is bad news for our strangle play unless AEOS can rally over $27.50 before the end of next week. For this strangle play to have a chance at exiting at breakeven or better then AEOS needs to trade above $29.50 or under $20.00. We are not suggesting new plays. The current strangle has an estimated cost of $2.35 with the January $27.50 calls (AQU-AY) and the January $22.50 puts (AQU-MX). We have changed our target to breakeven at $2.35.

Picked on November 13 at $ 25.47
Change since picked: + 0.08
Earnings Date 11/15/05 (confirmed)
Average Daily Volume = 3.6 million


Abercrombie&Fitch - ANF - close: 67.50 chg: +0.54 stop: n/a

We do not see any change from our weekend update. Time is running out. We have two weeks left before January options expire. Currently ANF is trading over the $65 strike but not by much. We need to see the stock make a run for the $70 level if we want to exit near breakeven. We are not suggesting new plays at this time. The options in our strangle are the January $65 calls (ANF-AM) and the January $55 puts (ANF-MK). Our target has been adjusted to breakeven at $5.15.

Picked on November 13 at $ 59.67
Change since picked: + 7.83
Earnings Date 11/15/05 (confirmed)
Average Daily Volume = 2.7 million


Blue Coat Sys. - BCSI - cls: 42.30 chg: +0.94 stop: n/a

BCSI got a bounce today after an analyst started coverage on the stock with a "buy" rating. BCSI needs to trade under $39 or well over $50 if we are going to be able to exit at breakeven. Last week we adjusted our target to breakeven at $3.25. We are not suggesting new plays. Our current play involves the January $50 call and the January $40 put.

Picked on December 04 at $ 45.43
Change since picked: - 3.13
Earnings Date 02/14/06 (unconfirmed)
Average Daily Volume = 416 thousand


Building Materials - BMHC - cls: 78.99 chg: -1.34 stop: n/a

BMHC's rally has stalled under its three-month trendline of resistance. We are not suggesting new strangle positions at this time. The options in our strangle play are the March $90 calls (BGU-CR) and the March $70 puts (BGU-ON). Our estimated cost is $8.20. Our target is $12.50 by March expiration.

Picked on December 18 at $ 80.95
Change since picked: - 2.06
Earnings Date 01/24/06 (unconfirmed)
Average Daily Volume = 527 thousand


Chicago Merc. Exchg. - CME - cls: 386.00 chg: +6.46 stop: n/a

We are running out of time. There are less than two weeks left before January options expire. At the moment if we have any hope of exiting near breakeven we need to see CME trade under $340 or above $410 and do it pretty quickly. Odds of that happening don't seem very high at the moment. We are not suggesting new plays. Our current play involves the January $400 calls (CMJ-AK) and the January $350 puts (CMJ-MA).

Picked on November 20 at $375.90
Change since picked: +10.10
Earnings Date 01/24/06 (unconfirmed)
Average Daily Volume = 879 thousand


Encana Corp. - ECA - close: 45.40 chg: -0.16 stop: n/a

Perfect! ECA pulled back and gave us another opportunity to open strangle positions at the $45.00 level. We're suggesting opening strangle positions in the $44.00-46.00 range. We would prefer to open new positions in the $45.25-44.75 region. We are using the April $50 calls and the April $40 puts. Our estimated cost is $3.45. At current prices that means we're betting that ECA will be trading under $36.50 or over $53.50 by April option expiration.

Picked on January 10 at $ 45.56
Change since picked: - 0.16
Earnings Date 01/25/06 (unconfirmed)
Average Daily Volume = 4.4 million


Four Seasons - FS - close: 55.38 chg: +0.96 stop: n/a

We have nothing new to report on for FS. Last week's breakout over its 50-dma and its multi-month trendline of resistance and lower highs has all but killed this strangle play. We have two weeks left before January options expire. The options in our strangle were the January $60 calls (FS-AL) and the January $50 puts (FS-MJ). We have adjusted our target to breakeven at $2.60.

Picked on November 08 at $ 55.37
Change since picked: + 0.01
Earnings Date 11/10/05 (confirmed)
Average Daily Volume = 319 thousand


Lear Corp - LEA - close: 25.71 chg: -2.53 stop: n/a

Today's action in LEA is very welcome. The stock lost almost 9% on volume more than four times the daily average, which is very bearish. Investors were not happy to hear that LEA is going to take a $342 million charge or write down for goodwill in the fourth quarter. We have less than two weeks left before January options expire. If we have any hope of exiting near breakeven then LEA needs to trade over $35 or under $25 pretty soon. We are no longer suggesting new strangle positions. The options in our strangle are the January $35 calls (LEA-AG) and the January $25 puts (LEA-ME). We have lowered our target to breakeven at $1.60.

Picked on November 06 at $ 30.24
Change since picked: - 4.53
Earnings Date 01/25/06 (confirmed)
Average Daily Volume = 1.8 million


Questar Corp. - STR - close: 80.25 chg: -0.26 stop: n/a

We are not suggesting new positions. Time is quickly running out. We have adjusted our target to breakeven at $5.10. Our strangle involves the January $80 calls (STR-AP) and the January $70 puts (STR-MN).

Picked on November 20 at $ 76.25
Change since picked: + 4.00
Earnings Date 01/26/05 (unconfirmed)
Average Daily Volume = 716 thousand


Texas Ind. - TXI - close: 53.96 chg: -0.43 stop: n/a

The new rally in TXI has paused. We don't see any change from our previous updates. We are not suggesting new plays. The options in our strangle are the January $55 calls (TXI-AK) and the January $45 puts (TXI-MI). Our target has been reduced to breakeven at $2.70. A move into the $57-58 range might be enough to get our strangle there.

Picked on November 27 at $ 49.57
Change since picked: + 4.39
Earnings Date 01/05/06 (confirmed)
Average Daily Volume = 354 thousand

Dropped Calls

Cytec Ind. - CYT - close: 47.18 chg: -0.82 stop: 45.95

The relative weakness in CYT is picking up speed. We see today's decline as the forerunner to a breakdown of its bullish trend. If you're feeling optimistic CYT does still have some support at the $47.00 level. You might want to hold on for another day or two and see if CYT bounces from $47.00 but we would tighten stops if you do hold on. We are choosing to exit early! We would not hold over its earnings report.

Picked on December 22 at $ 47.01
Change since picked: + 0.17
Earnings Date 02/09/06 (unconfirmed)
Average Daily Volume = 333 thousand


Foster Wheeler - FWLT - close: 43.11 chg: +2.14 stop: 37.75

Target achieved. FWLT continues to show great relative strength. The stock added 5.2% today on volume more than three times the daily average. Our target was a rally into the $42.00-42.50 range. The move was fueled by news for FWLT. The company announced it had won a $200 million contract to build the world's largest CFB boiler island in Poland.

Picked on January 05 at $ 38.05
Change since picked: + 5.06
Earnings Date 03/15/06 (unconfirmed)
Average Daily Volume = 598 thousand

Dropped Puts


Dropped Strangles



Trader's Corner

'Gaps': When It's Important Where Trading Was 'Not'

Continuing my New Year's resolution with my weekly (Trader's Corner) Wednesday column is to write about technical/market analysis principles reflected in current or recent chart patterns and/or Indicators. (It's up to you dear Readers to send any other questions about a pattern, indicator or whatever (re trading) that might not be reflected in recent or current market activity.) Taking this approach will tend to insure that I keep to relevant aspects or ones that could help you spot a similar pattern or cycle NEXT time to sharpen your trading decisions.

I try to do some of this in my weekend Index Trader column, which is seen online only (not in the Option Investor Newsletter/OIN e-mail, although you'll see a LINK to it at the top. Speaking of links to my 1/7 Index Trader, it also can be viewed/reviewed by clicking here.

A price chart 'GAP' is formed when any traded item, commodity, stock, index, etc. has a low that is the ABOVE the prior session High, which is an 'upside gap'; or, when a stock or index high is BELOW the previous session's Low, creating a 'downside gap'.

Gaps are price areas where no trading took place from one session to the next. On daily charts, this creates a space between two consecutive days price ranges as seen on a bar (or candlestick) chart. Gaps have different kinds and degrees of significance in predicting possible trend continuations or reversals that may be underway.

Price gaps most often occur on overnight news; news that came out after the close of trading, such as company earnings announcements, changes in analyst ratings, something the Fed does, etc.

Generally, gaps below the market tend to act as support areas and gaps above the market suggest resistance and areas where there will be likely selling interest. Since a consensus expectation is 'built into' the last traded price or close of every stock or Index, significant new influences affecting the markets perceptions of what the price level should be, causes an immediate adjustment in the opening price.

Buyers will either be willing to pay more and potential sellers will want higher levels to induce them to sell or sellers will be aggressive in offering the item at lower levels and buyers will not be interested in purchasing unless prices drop especially in the early trading (open) which often becomes the high or low.

UPSIDE GAPS are price areas where buyers were unable to make any purchases, as selling occurred only above the gap area. DOWNSIDE GAPS are price areas where sellers were unable to make any sales as they could only transact at levels below the gap.

This is what is behind the notion that gaps BELOW the market will tend to act a support and gaps ABOVE the market, will tend to act as resistance. A move back down to an upside gap often brings in additional buying, unfulfilled at this lower level from earlier and a rebound back up to an overhead (downside) gap can attract interested sellers that would have sold more in the area where prices had previously 'gapped' down.

There is a common saying that "gaps get filled in"; that is when a market settles down in subsequent days and weeks after the gap 'event'. It would be better to say that gaps TEND to get filled in since gaps dont always get 'filled'.

Gaps can be 'common' and not very significant in terms of the trend or future support or resistance OR can indicate a big shift in the rate of upside or downside MOMENTUM; this is when 'runaway', sometimes called 'measuring', gaps are created. Sometimes gaps suggest the current trend is reaching it's end; that it (the trend) is exhausting itself, which become so-called 'exhaustion' gaps. These indicate an upcoming trend reversal (rather than trend 'continuation').

'Common' gaps are, in a word, common and occur frequently, especially in stocks. Such gaps are part of normal price activity and are not especially significant. These gaps get 'filled in' regularly. In the stock market, because of the tendency to halt trading in a particular company if news comes out that affects the stock price, resumption of trading can easily result in a price gap.

A 'breakaway' gap, as the name implies, is a gap that bursts out of the pack so to speak; that is, a gap that develops when prices jump well above or below what has been normal trading up until this gap event. This type of gap can be the first 'signal' of a trend reversal; e.g., the trend was down, but then an upside breakaway gap began a trend reversal from down to up.

A 'runaway' or 'measuring' gap describes a gap occurring when a trend ACCELERATED in the direction of the trend indicated by the initial breakaway gap or the trend that simply existed beforehand; this can be an upside or downside chart gap. This kind of gap or trend change occurs more in the second phases of bull or bear markets when there is increasing interest, or lack of interest, in a stock or the overall market.

The measuring gap moniker is because of its sometimes 'measuring' implication for the further possible upside or downside potential of the move underway; such gaps often (not always) appear about midway in a price swing.

The first significant gap seen in the daily chart of eBay below, occurred early in 2005 and is best described as a breakaway gap. The decline really accelerated after this price gap. The first time that the stock rebounded to the lower end of this huge gap, it didn't get very far into the gap area, until selling drove the stock lower again.

The second gap, in early-August, was one to the upside and was also a significant gap of the breakaway type., The trend changed after that, although as noted, the rally failed on the first move that was much into the major downside gap of early last year. However, the subsequent pullback toward the lower end of this second gap, found enough buying interest to drive EBAY back up again.

By the way, the significant upside gap in eBay's chart above, occurred after a picture perfect formation of a bullish flag pattern. I say picture perfect because price action over those days traced out something that looks exactly like a down-sloping flag, after a strong run up that preceded this formation; i.e., a more or less straight up move that resembles a 'flagpole'. I show this pattern on the OEX hourly chart that follows, but I won't comment more on this pattern and stick to the subject at hand.

Gaps are not really seen on the S&P 500 index (SPX) or Dow Industrial (INDU) DAILY charts. You have to go to hourly charts to see an 'actual' gap on the SPX or OEX charts. (You won't see upside or downside gaps on the hourly INDU chart at all because of the way INDU is computed even on an intraday basis.)

Gap 'events', such as when some overnight news 'surprises' the market may cause substantial buying or selling orders to show up prior to the Opening. That also means order imbalances show up in a number of S&P stocks (i.e., the orders are MOSTLY buy or mostly sell orders) and the opening gets delayed for that stock or a bunch of stocks to allow more orders on the other side to accumulate. Under the NYSE specialist system, which is going to come to an end I suppose as it becomes fully electronic like the Nasdaq, such delayed openings was part of their duty to create an 'orderly' market.

As the Standard & Poor's Corp. (and it is their Index), wants to publish a daily 'Open' right away, their method has been to calculate the open for stocks not immediately trading, based on their 'last' price, or the prior Close. Based on this method, there is no apparent chart 'gap' on the S&P indexes. An HOURLY chart is used for the S&P 100 (OEX), where the 'Open' is based on the actual first trades, to see where price gaps show up.

The 'exhaustion' gap, which tends to be even more common in the futures markets but is also seen some in stocks and in the indexes, occurs after a trend has been underway for some time. It typically stems from a final last burst of buying or selling activity that 'exhausts' the participants or depletes their accounts.

Without subsequent price action that rallies or falls quickly above or below the GAP area, a so-called exhaustion gap would not be easy to distinguish from other types of gap. Again, this type gap occurs at the END of a move, just ahead of a trend REVERSAL.

As soon as the top end of the downside gap on the S&P 100 (OEX) was exceeded (and note that the initial rally 'failed' to do so), as part of a STRONG move (with heavy volume), this was an excellent technical 'signal' or 'confirmation' that the trend had reversed. Big time! This was going to be a strong rebound!

Most of what I have to say or show about the trading significance of the OEX 'exhaustion gap' is noted on the above hourly chart above.

On to the Nasdaq, where chart gaps ARE apparent on the DAILY chart, as the initial trade for ALL stocks making up either the Composite (COMP) or the popular Nasdaq 100 (NDX) trading index, are computed to give a 'true' opening so to speak. Nevertheless, I end my gap discussion with the NDX hourly chart, as the gaps are easy to see and highlight.

The first gap highlighted, to the left of HOURLY chart below, is the upside price gap of late-November. That burst of buying looked like it could be the start of a sustained advance. Support on the initial pullback did find buying interest/support at the low end of this price gap. When this level was pierced it suggested that prices were headed LOWER.

The recent late-December downside gap, looked like it was might be marking the start of another substantial downswing. The first rally back to the gap area couldn't make headway above it. But a few hours into the New Year (1/3) trading session, the Index reversed strongly to the upside. The decisive upside penetration of the upper end of the late-December downside price gap now suggested that the decline had played out or exhausted itself. This was a strong 'signal' to both exit any NDX puts held and reverse positions into Index calls.

The more recent upside price gaps seen on the NDX chart above had the possible 'measuring' implications of being at (only) a midpoint of a 'runaway' or strong move. As of the close today, the price leg occurring after at least the first smaller gap, has tacked on as many additional points as from the low to that gap area.

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **  

Today's Newsletter Notes: Market Wrap by Linda Piazza, Trader's Corner by Leigh Stevens and all other plays and content by the Option Investor staff.


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